Since the performance of active and passive strategies runs in cycles, it's important to set clients' expectations.
Clients have been fleeing from large-cap actively managed funds for years. In 2014 alone, despite a relatively strong one-year return from the group a gain of 10.72% clients redeemed some $34.5 billion from actively managed large-cap funds, while they padded the coffers of passively managed funds by some $17.4 billion.
Nonetheless, the actively managed large-cap funds group is still the largest group in the equity universe, with $1.6 trillion under management, while its passively managed brethren (excluding S&P 500 funds) have a little over $335 billion under management.
A WEAKENING BULL
While, on average, passively managed funds have outpaced their actively managed counterparts, there are certain times when actively managed funds do outperform.
When bull markets start to lose their steam and stock picking comes back into vogue or when markets are in a funk, research has shown that actively managed funds are often poised to post better returns than their passively managed counterparts.
Through June 30, in a sideways stock market, actively managed large-cap funds were up 1.95% year to date, outperforming passively managed large-cap funds, which were up 1.33%.
To help explain performance trends of actively managed funds vis-à-vis their benchmarks, advisors will find it useful to dive deeper into portfolio practice.
An examination of Lipper's Large-Cap Core Equity funds classification takes advantage of the use of attribution-analysis tools. The allocation effect refers to underallocation or overallocation by a fund of a particular industry sector.
A manager's stock selection decisions compared with the composition of the benchmark's holdings is known as the selection effect.
Attribution analysis gives us a way to assign performance qualities to the manager's portfolio allocation choices and to his or her selections.
For 2014, ignoring the impact of expenses on returns, the average actively managed Large-Cap Core Equity fund was up 13.13%, underperforming the S&P 500 daily reinvested composite (up 13.65%) by 52 basis points.
EXPLAINING A LAG
A deep dive into the data shows that the average actively managed LCCE fund lagged the benchmark by 2 bps because of allocation effect, while stock selection led to underperformance of 50 bps.
In particular, an overallocation to poorly performing stocks in the finance sector (such as Genworth Financial, Standard Charter and Ocwen Financial) weighed heavily on active LCCE funds compared with the benchmark, with an economic sector selection effect of minus 51 bps. On the flip side, a slight overweighting in consumer discretionary stocks, with superior stock returns within that subgroup compared with the benchmark, helped the average actively managed LCCE funds return, adding 29 bps to the total effect (allocation effect and selection effect combined).
However, so far in 2015 and again ignoring expenses the average actively managed LCCE fund (1.71%) outpaced its benchmark (1.19%) by 52 bps. This consisted of an allocation effect of 28 bps and a selection effect of 23 bps.
The average actively managed LCCE fund was slightly overallocated to health care stocks compared with the S&P 500's allocation, boosting the comparative return 5 bps, while the average portfolio manager's health-care stock-picking abilities added some 9 bps to the overall return.
On the chart above, fund expenses are not included, in order to provide an apples-to-apples comparison. This analysis is based on portfolio construction, comparing allocation and stock-picking impacts before the consideration of expenses, which are generally easy to assess. Once the trend of the group is found, it is an easy mathematical exercise to slot in expenses. This type of review helps us isolate the pros and cons of various fund groups or individual funds.
Attribution analysis can be used as well to highlight funds with superior and inferior performance within a classification, and it can provide a clear explanation of why those findings occurred.
As an example, Lipper has identified one of the best performing funds in the LCCE classification in the one-year period that ended June 30, PNC Large Cap Core Fund (PLEIX), and have run it through attribution analysis to find out how it achieved its outperformance.
While this is not a substitution for risk-adjusted return analysis, it provides one more piece of the puzzle, helping us offer detailed explanations to our clients. The following is provided as an example only and is not intended to be a recommendation of any sort.
PNC Large Cap Core posted a one-year return before expenses of 12.66%, while its benchmark the S&P 500 returned 7.36%. According to attribution analysis, the fund had an allocation effect of 1.28% and a selection effect of 4.02%.
While the PNC fund was slightly underallocated to the information technology sector, providing an allocation effect of zero, the portfolio managers stock selection within the sector was the primary factor of outperformance.
Picking winning securities provided a selection effect of 2.51%, with significantly higher weightings to Skyworks Solutions and NXP Semiconductors being big contributors for the period.
Equally, a lower allocation to the underperforming energy sector during the year compared with the benchmark helped the fund mitigate losses to its portfolio, adding 75 bps to the allocation effect.
A LESS POSITIVE RESULT
Another, perhaps more recognizable, example is American Funds Investment Co. of America. (AIVSX). This fund posted a one-year return of only 4.41%, compared with the benchmarks 7.36% return. Attribution analysis shows the fund had a negative allocation effect of 1.33% and a negative selection effect of 1.62%.
While the fund's heavier weighting in Merck placed a 49-basis-point drag on the portfolio, it was underallocated to the healthcare sector compared with its benchmark, tagging on an additional 94 bps of drag from that sector alone.
In the debate over passive versus active management of a portfolio debate, there are times when one approach is better than the other.
Knowing that time can be difficult, so steering clients to both actively and passively managed products can often be the right decision.
Providing examples of when certain sectors are out of favor, when markets are flat or when the manager is truly providing alpha can be accomplished using attribution analysis, which supports the inclusion of actively managed products.
While even proponents of passive management often give the nod to actively managed funds in the less efficient fund groups (emerging markets, small-caps and municipals), attribution analysis and good research can help ferret out some hidden gems, even in well-covered, widely held classifications.
Tom Roseen is a contributing writer for On Wall Street and the head of research services at Lipper.